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How do private equity investors create value? (European Study)

Private equity industry outlook

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The study, based on the largest European businesses owned and exited by private equity from 2005 to 2010, demonstrates the resilience of private equity even through the coldest of climates.

The PE business model is a robust and active form of ownership that drives growth in the companies it backs through fundamental and transformative change. This is good for the economy as a whole but also for PE, which our study shows consistently out-performs the public markets as a result.

PE buyers are setting the quality threshold higher

Secondary buyouts have accounted for a large share of the exits in 2010, driven in part by a defrosting of the debt markets. There is, however, anecdotal evidence to suggest that PE buyers are setting the quality threshold higher on deals sourced from PE portfolios in response to LP concerns around how much value can be added to companies by successive PE owners.

Exit activity has improved, although the market is also not yet at full capacity. Corporates have not yet staged a major comeback on the M&A market, despite having built up significant cash reserves. There are some signs of their return in sectors such as IT and healthcare, but corporates will remain highly selective in the acquisitions they undertake.

Given that trade buyers have always been an important exit route for PE, exit figures will not reach their potential until corporates are fully back in the market. Additionally, the uncertain economic climate is impacting confidence. As a result, PE still faces the challenge of needing to realize a large number of companies in its portfolio.

For the third year running, PE portfolios have continued to age rapidly. In December 2009, the average holding period of investments was 3.6 years; by December 2010, it was 4.2 years. PE remains under pressure to step up the pace of exit activity to ensure returns as measured by IRR are not dampened further.

It is also facing pressure to return capital to LPs, particularly where firms are likely to need to raise new funds over the next 12 to 18 months. However, LPs are not just seeking crystallized returns from the PE firms they will back in the future. They are also increasingly looking for evidence of operational improvement in PE portfolio companies.

The fund investment process has professionalized significantly over the last few years and LPs are conducting much more thorough due diligence on new PE funds than they have in the past, drilling down into each PE manager’s ability to add value. As our research highlights, PE is increasingly focusing on growing the businesses it backs.

Those able to demonstrate a well-defined strategy of choosing the right markets to invest in and successful execution of value creation plans in their portfolio companies should continue to attract good levels of LP capital.

Private equity faces increased regulation

At the same time, PE continues to face the pressure of increased regulation both within Europe and on a global stage. While some of this has already come into force and PE is rising to the challenge of implementing the necessary changes, the full effects of a stricter regulatory regime governing the industry may not be known for many years to come.

As this year’s study demonstrates, the PE model is alive and strong. It has remained resilient even through the harshest of environments. The full recovery of European economies may be further out than was expected in 2010 and PEs will need to utilize all of the lessons learned throughout the recession to steer portfolio companies through some more uncertain times ahead.

However, our study shows that PE’s active ownership enables it to withstand difficult conditions by driving growth in the companies it backs, to create stronger, more profitable businesses over the longer term and to generate investment returns that out-perform public market benchmarks.

EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients.